Planning for future required amortization of research expenses
The TJCA resulted in significant changes to for the treatment of Research and Experimentation (R&E) expenditures. Before tax years beginning after Dec. 31, 2021, taxpayers still have an option of how to treat R&E expenditures under section 174 on their tax returns. Currently, two options are available for taxpayers – direct expensing of R&E expenditures when paid or incurred, or capitalization and amortization over no less than 60 months from when the taxpayer first begins to derive benefit from the R&E. However, under the TCJA, taxpayers will have far fewer options and far less flexibility in treating these expenditures.
For tax years beginning after Dec. 31, 2021, taxpayers must capitalize and amortize all R&E expenditures paid or incurred in connection with their trade or business. The straight-line recovery periods are five years and 15 years for domestic and foreign incurred R&E, respectively, and the midpoint of the tax year is utilized as the convention for the first year of amortization. As a further whipsaw to taxpayers, capitalized R&E must continue to be amortized over the remaining five or 15 year life even if a research project is abandoned, disposed of, or retired. Historically taxpayers have taken the position that the remaining basis could be written off upon abandonment or disposition. Ultimately, these new rules do not prevent a taxpayer from taking a deduction for R&E, however they very much impact the timing of when taxpayers are allowed to take that deduction.
So what happens after Dec. 31, 2021 to taxpayers who are currently expensing R&E expenditures or amortizing over a period of more than five years? The IRS generally requires consistent accounting methods treatment of items from year to year, unless a change in method is requested with the IRS. In order to switch to capitalizing over the new required periods, taxpayers are instructed to self-initiate an automatic accounting method change without a historical section 481(a) adjustment for all expenditures paid or incurred after Dec. 31, 2021. This ‘cut-off’ or prospective-only change has not yet been addressed in IRS procedural guidance, so taxpayers will need to wait for formal guidance .
It should be highlighted that taxpayers incurring software development costs may also have negative consequences beginning after 2021. The new Section 174 adds a specific provision which defines software development as R&E, essentially voiding expense treatment under Rev. Proc. 2000-50. This further restricts taxpayer’s ability to deduct software development costs (e.g. under Rev. Proc. 2000-50 as a direct expense or 36 month asset), however this new treatment may provide a glimmer of opportunity to more easily qualify software development expenditures for the research and development tax credit, as treatment under Rev. Proc. 2000-50 has been a historical point of contention with the IRS.
In summary, the TCJA imposes very strict requirements for capitalization and amortization of R&E expenditures with little hope for direct expensing. Since these rules go into effect for tax years beginning after Dec. 31, 2021, taxpayers may still continue their current expense treatment through that date. Further, and as of the date of this publication, taxpayers still have the ability to utilize automatic accounting method changes in Rev. Proc. 2017-30 under section 174 (prospectively for all R&E on a project-by-project basis) or under Rev. Proc. 2000-50 (with historical section 481 adjustment, for software development expenditures) to change their current treatment to take advantage of direct expensing or shorter amortization periods while they are still available.